Trust Matters, and Misleads

Carlos Lozada looks at three books limning the Madoff scandal and concludes that the financier at the center of them wasn't a genius or a legend, but a pretty good con man running a simple scheme. And the central feature of the scheme, viewed in the clear light of its collapse, seems to have been this: "[I]n investing, trust matters as much as greed. And investors trusted Madoff. They knew him, or his family, or his friends, or they trusted the intermediaries who sent their money to him."

That's not only a plausible explanation of how Madoff convinced his investors that the laws of financial gravity had lifted, but how the financial industry did the same for the country, not to mention itself. Every bank felt more comfortable going into this madness because every other bank was walking in as well. And if all the banks were trading these products and trusting these trends, then what reason was there for the rest of us to worry about the fundamentals of the market?

So the presence (and returns) of the professionals convinced the other professionals, and that in turn convinced everyone else. At every point in the process, there were enough trusted participants to quiet the doubters. That's what made the graph atop this post believable. Sure it seemed weird that the buy-to-rent ratio had changed beyond all recognition, even though there was no obvious reason for buying to suddenly become so much more valuable than renting. But were you really sure you understood the housing market better than the people who did this stuff for a living?

Madoff was knowingly defrauding people, while everyone else was defrauding themselves. Morally, that matters. But on a more fundamental level, the lesson of this crisis seems to be that things are rarely different, even if all the experts think they are. Fundamentals are fundamentals, and anyone arguing that they've changed needs a pretty good explanation for why. Social proof isn't enough, even though it feels like it is.

I'm not sure how much difference there was morally. Yes, Madoff skimmed off huge amounts of money (as did the banks) but for years didn't the people who invested with Madoff makes a very comfortable return? Isn't that the essence of a Ponzi scheme? That is, it wasn't just that people trusted Madoff and trusted the people who trusted Madoff but that the latter were making very impressive amounts of return. And then they finally hit the rule of the last fool and the whole thing rolled back on itself, blasting the people who hadn't taken their winnings and left the game.

That sounds awfully like the housing bubble to me, whatever moral distinctions you want to make.

It's more than just evidence, it's risk. If you as an investment manager make the same giant mistake that almost everyone else did, including people considered top professionals, you probably won't lose your job, reputation, career.

But, if you bet against a bubble, even if you are 95% sure you're right, in the 5% instance that you're not, you can easily be ruined, losing your super high paying job job, and maybe also your reputation and career.

And even if you're 100% sure the bubble will pop over the next 5 years, if it inflates more over the next 2, you could lose your job well before the bubble pops. Mike Konczal discusses this point (at: http://baselinescenario.com/2009/08/21/the-limits-of-arbitrage/ ) made in a famous Shleifer and Vishney academic finance paper.